Question

Question 1

Delcy Incorporated operates out of Guam Island, but is currently experiencing financial shocks due the Covid 19 pandemic plaguing the world. As a strategy to deal with the financial fallouts associated with this pandemic, Delcy   is exploring two possible capital structures as follows;

• Capital Structure 1 - 40,000 shares with $540,000 in debt.
• Capital structure 2 – 30,400 shares with $1,188,000 in debt.

. Delcy’s current interest rate on debts and other loans are 8%.

1-     You are required to compare both plans above to an all equity plan. Delcy’s all equity plan have 48,000 shares outstanding and Delcy’s EBIT is currently $240,000. Which plan will have the highest EPS?    

2-     What are the breakeven levels of EBIT for each plan   as per part, as compared to the all equity plan? Discuss your answer.  

3-     When will EPS be identical for Capital structure 1 and 2?   

4-     Repeat items 1, 2 and 3 assuming a tax rate of 40%. Are the breakeven levels of EBIT different from before? Explain you answer.                     Total 25 marks

Answer 1

1.

	All Equity Plan	Capital Structure I	Capital Structure II
EBIT	$ 240,000	$ 240,000	$ 240,000
Interest Expense	0	43,200	95,040
Eanings before Taxes	240,000	196,800	144,960
Taxes	0	0	0
Net Income	240,000	196,800	144,960
Common Shares Outstanding	48,000	40,000	30,400
Earnings per Share	$ 5 per share	$ 4.92	$ 4.77

The all equity plan will have the highest EPS.

2. Let the breakeven level of EBIT be E.

Break-even EBIT happens where EPS is equal for both plans.

Between All Equity Plan and Plan 1 :

E / 48,000 = ( E - 43,200) / 40,000

or 40,000 E = 48,000 E - ( 48,000 x 43,200 )

or E = $ 259,200

Between All Equity Plan and Plan 2 :

E / 48,000 = ( E - 95,040 ) / 30,400

or 30,400 E = 48,000 E - 95,040 x 48,000

or E = $ 259,200

3. Breakeven EBIT for Capital Structure 1 and 2 :

( E - 43,200 ) / 40,000 = ( E - 95,040) / 30,400

30,400 E - 1,313,280,000 = 40,000 E - 3,801,600,000

E = $ 259,200.

EPS will be identical for both Plan 1 & Plan 2 when EBIT = $ 259,200.

4.

	All Equity	Plan 1	Plan 2
EBIT	$ 240,000	$ 240,000	$ 240,000
Interest expense	0	43,200	95,040
Eanings before Taxes	240,000	196,800	144,960
Taxes @ 40 %	96,000	78,720	57,984
Net Income	144,000	118,080	86,976
Common Shares Outstanding	48,000	40,000	30,400
Earnings per Share	$ 3	$ 2.952	$ 2.861

The break-even level of EBIT will be the same.

0.60 E / 48,000 = ( E - 43,200) x 0.6 / 40,000

or 24,000 E = 28,800 E - 1,244,160,000

or E = $ 259,200